Loading...

By:Jin Choi

The Price-to-Earnings (P/E) ratio is probably the most popular metric used by casual value investors. We calculate the ratio for each company using the following formula:

market_cap = price_per_share * number_of_shares_outstanding price_to_earnings = market_cap / net_income

Investors consider low P/E companies to be cheap, and many people hunt for opportunities exclusively among those stocks possessing low ratios. Historical records validate such tactics. Investing in low P/E stocks would have led investors to outperform the markets when done so over many decades.

The ratio derives its potency from its link to the company's intrinsic value. Recall that intrinsic value is the cumulative money you'd receive for holding a security until you're forced to relinquish it. We should expect companies with greater earnings to have higher intrinsic values, so buying stocks with low P/Es should be commensurate with paying less for intrinsic values.

Consider a company currently trading at $50 billion that earns $5 billion until the end of time. If this company distributes all its earnings as dividends, then the rate of return enjoyed by its shareholders would be $5 / $50 = 10% per year. Notice that the rate of return in this case is the inverse of the P/E ratio of $50 / $5 = 10. If the company traded at $25 billion instead, the P/E ratio would be lower at 5, and the rate of return would be higher at 20% per year.

Unfortunately, the above example contains many implicit assumptions which are violated in practice. There are, therefore, some significant caveats to using P/E ratios to determine whether a company is cheap.

One problem is that P/E ratios omit any mention of a company's liquidation value. A company holding $100 million in cash per share earning $1 million yearly should still be worth close to $100 million. But if it does, the P/E ratio would be close to 100, making the company seem rather expensive.

Focusing on P/E ratios can also blindside you to changes in a company's profits and its impact on intrinsic value. A company that earns $5 billion this year and nothing thereafter should be valued at $5 billion at most. But at $5 billion, the company would have a P/E ratio of 1 and look enticingly cheap.

Another problem with P/E ratios is that the 'net income' number can be highly erratic because of accounting quirks. An example of such a quirk is the accounting 'write-off,' which involves marking down the value of an asset in the company's books. But such write-offs don't necessarily reflect declines in the company's liquidation value. For example, AT&T's write-off of $25 billion in 2022 amounted to an admission that they paid too much to acquire a subsidiary. The value of the subsidiary's hard assets didn't decline by $25 billion, but AT&T's outlook on the subsidiary's profitability did. Many other accounting quirks can similarly obscure a company's true profitability.

Finally, P/E ratios tend to favour highly indebted companies. A hypothetical company earning $2 billion annually, valued at $40 billion with no debt, would have a P/E ratio of 40 / 2 = 20. If this company borrows $10 billion to buy back shares, its market cap will decline to $30 billion. Assuming the interest rate on the debt is reasonably small, the company will still earn close to $2 billion and have a P/E ratio of 15. The underlying business has stayed the same, but the company looks cheaper.

Given all of these problems, it's a wonder that investing in low P/E ratios has worked. But it has. Although P/E ignores liquidation value, a company's future earnings potential usually dwarfs it in magnitude. Though P/E lacks focus on earnings changes, companies' future earnings have tended to remain relatively stable. Despite its accounting quirks, net income has tracked true profitability over longer timeframes. Companies also manage their debt load, limiting the impact of debt on P/E ratios.

As long as the abovementioned dynamics hold so that low P/E stocks continue outperforming, quants will keep the P/E ratio as part of their toolkit. But that doesn't mean quants will use it as their primary valuation tool. Some metrics partially address P/E's problems, and we'll turn to those metrics next.